Individual Income Insights: Maine’s Denial of Credit for Tax on Pass-Through Entity Income Passes Constitutional Muster

The general rule in state tax is that there is no general rule. And states make no exception when it comes to taxing pass-through entities. Even though most states typically skip entity-level taxes, instead taxing the individual members on that income, it may not necessarily be the case when dealing with multiple states with different taxation systems.

Recently, an individual resident of Maine challenged Maine’s rules on its income tax credit for income taxes paid to another state, arguing she could claim a credit for business taxes paid in New Hampshire by a limited liability company, of which she was a member. The Supreme Judicial Court of Maine ruled on Aug. 2, 2018, in Goggin v. State Tax Assessor that the resident was not entitled to a refund of personal income taxes for business taxes paid to another state.

Goggin’s Tax Grievance

Ann Goggin, a Maine resident, was a member in a New Hampshire LLC. For the years at issue (2012 through 2014), due to the LLC’s classification as a partnership for federal and Maine income tax purposes, Goggin received a proportionate share of the LLC’s rental income that flowed through to her.

While New Hampshire is one of seven states without an individual income tax, the state imposes a business profits tax and a business enterprise tax on corporate and pass-through entities, including LLCs. On its federal partnership return, the LLC took deductions for the New Hampshire business taxes paid. Thus, Goggin’s income from the LLC equaled a percentage of the reduced amount on the LLC’s Schedule K-1. Goggin and her husband filed a joint Maine return reporting her share of the LLC’s income, less the New Hampshire business taxes paid. In 2016, the couple filed a Maine personal income tax credit claim for the portion of New Hampshire business tax paid by the LLC proportional to Goggin’s membership interest. The Maine Revenue Service denied the refund claim. Earlier this month, the Supreme Judicial Court of Maine affirmed.

The Court’s Ruling

The court’s decision upheld the Maine Revenue Service’s position that the income tax credit under 36 M.R.S. § 5217-A is available only for income tax that a resident individual has paid in another state by looking at the plain language meaning of the statute. The statute states that the credit is allowed for “income tax imposed on [an] individual.”

Additionally, the court rejected Goggin’s constitutional argument that disallowing the credit would result in a violation of the Commerce Clause, namely the second and third prongs of Complete Auto Transit Inc. v. Brady. The U.S. Supreme Court in Comptroller of the Treasury v. Wynne clarified that to meet Complete Auto’s third prong (that a tax cannot discriminate against interstate commerce) the tax must meet the internal consistency test. This test asks whether the identical application of a tax statute by every state would result in “disproportionate taxation of out-of-state income.” In Wynne, Maryland’s individual income tax violated the Commerce Clause because it did not include a credit for taxes paid to other states against county level income taxes that were administered by the state. The court held that Wynne did not apply to the given facts since Maine expressly allows for a credit for individual income taxes paid to other states. Rather, the court noted that New Hampshire’s “unusual scheme” of taxing pass-through entities led to the discrepancy.

The court also rejected Goggin’s argument that disallowance of the credit violated the external consistency test, which examines whether a tax is fairly related to the services provided by a state under the third prong of Complete Auto. The court simply stated that the test has not been applied to individual income taxes “because of the established legal principle that residence in a state and the consequent enjoyment of the protection of its laws provide a basis for the taxation of individuals’ income.”

While Maine and New Hampshire may be neighbors, they treat taxation of pass-through entities entirely differently. Maine conforms to the federal treatment of pass-through entity income tax (i.e., skipping over the corporate entity and taxing the individual). However, New Hampshire does not conform, thus potentially giving rise to double taxation as in Goggin’s case. Taxpayers should be aware that forming a pass-through entity may not be a bullet proof solution to states’ variable taxation schemes.

Continue the discussion on Bloomberg BNA’s State Tax Group on LinkedIn: Do states’ taxation schemes for pass-through entities create disincentives to form such entities?

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